China unlikely to sell off its US debt holdings: TD

China is unlikely to adopt the "nuclear" response of significantly selling down its vast holdings of US Treasuries, amid its escalating trade dispute with the US, according to TD Securities.

"We don't believe that China will sell much of their Treasury holdings as it would be counterproductive for their economy," TD's Priya Misra, head of global rates strategy, and Gennadiy Goldberg, senior US rates strategist, said in a note.

China is the largest holder of US Treasuries with $US1.1 trillion worth of them.

"We view retaliatory Treasury selling by China as the 'nuclear' response to trade tensions and view it as the least likely of those presented here." Bloomberg

The TD strategists argue that China would have little to gain from significantly selling down those holdings.

"It would strengthen their currency too much or would negatively impact the value of their remaining Treasury portfolio. Further, capital outflows are currently much smaller than during the 2015-2016 period, when China needed to intervene to protect its currency."

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Historically, the strategists said, China has sold Treasuries to check a sharp depreciation in the yuan as well as check capital outflows and that remains the most likely reason why China would be a seller again.

As for the potential that China would initiate a sell-off to retaliate against the US, the strategists are sceptical.

"We view retaliatory Treasury selling by China as the 'nuclear' response to trade tensions and view it as the least likely of those presented here."

Another radical approach by China, in terms of selling Treasuries, could be to diversify its foreign exchange reserves out of US dollars into other currencies, the strategists said.

"This would be akin to the move taken by Russia in response to US sanctions, with Russian Treasury holdings declining from $US96 billion in March 2018 to just $US15 billion in May 2018."

"However, China's $US1.1 trillion portfolio and trade surplus with the US make this degree of selling much less likely," the strategists said.

Still, China has been a heavy seller in the past, and it has had a market impact.

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"From January 2015 to December 2016, we estimate that China (plus Belgium) sold $US430 billion of Treasuries. Note that these figures also include selling by Belgium because we believe China may have sold Treasuries through this custodian to disguise the magnitude of their selling flows.

"The selling was triggered by a change in PBOC's exchange rate regime, which then further exacerbated capital outflows and led to additional Treasury selling as the currency weakened.

"China was forced to sell Treasuries and buy RMB [yuan] in order to stabilise the currency, but not before creating significant market dislocations."

Among the reasons TD sees as offsetting the need to sell in volume are there are fewer capital outflows now than in 2015, selling would lower the value of the nation's remaining Treasuries, selling of US dollar assets would boost the yuan, selling could tighten financial conditions, and there are few substantial alternative investments.

Still, TD isn't ruling out some selling.

"The situation remains fluid and if capital inflows do pick up, it is possible that China will be forced to intervene and sell some Treasuries.

"We will keep an eye for the following signs that China may be selling: an acceleration of capital outflows, an increase in dealer inventories of off-the-runs, or a cheapening of off-the-run to on-the-run Treasuries."